Tuesday, March 4, 2008

Munch Fear ScReaming in the Equity Risk Premium

When trusted Financial genius Warren Buffet uses the ‘R’ word on CNBC, equity investors should be concerned. Warren Buffet is a no-nonsense Nebraskan who understands the intrinsic (melted down) value of every copper penny in his pocket. Investors should worry even more after the following quick explanation of the Equity Risk Premium (ERP).

The Equity Risk Premium (ERP) is an accounting metric used by Wall Street money managers and some studious individual investors (you, for example). Sure, it’s only a statistic, and statistics only reflect the past, but we’d hate to see any of our readers return from the Drive-In Theatre without a rear view mirror.

It’s pretty easy to calculate the ERP. Just take the historical yearly return of the U.S. stock market (roughly 10.4% dating back to 1900) and subtract it from the risk-free rate of return of the U.S. Government’s 30 year Bond, which yields 4.37% today. Got that? Okay.

That means today's U.S. equity Investor is getting an ERP of over 6%! Now most University Professor types would agree that the historical average of this metric favors stocks anytime it rises above 4%. And therein lies the problem: the stock market continues to fall in the face of a 6% premium reward for taking on risk. Does anyone remember 1987's ERP? That’s right, it was close to zero. It made good business sense then to abandon stocks and get comfortable with the nearly 10% that the US 30 year bond was yielding.

So why is there no traction lately?

Maybe there’s a much different problem involved than simple home grown statistics to explain the feaR in the ERP; perhaps the problem lies in overseas markets. So, Warren Buffet's use of the 'R' word on CNBC could still reverberate much, much more, perhaps around the Globe, maybe even, oh.. Asia?! Have you checked the Nikkei Index lately? Click the link, but be warned: you might let out a "munch" louder scReam than you did when you heard Warren Buffet admitting RRRrrecession.